The Overnight Report: Downgrade? What Downgrade?

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By Greg Peel

The Dow rose 213 points or 1.9% while the S&P gained 2.2% to 1204 and the Nasdaq added 1.9%.

The number from last night which underscores the sheer irrelevance of the Standard & Poor's downgrade of US debt last Friday week is 1204 – the close in the S&P 500. On that Friday, the S&P closed at 1200 and it was after the market that the ratings agency made its announcement. 

So what the hell was last week all about?

Volume on Wall Street was back to pre-downgrade levels last night, meaning less than half of some of last week's numbers. The volume trend has reduced considerably since the GFC and it's also the summer holiday period in the northern hemisphere at present. Stock prices did not as much surge as drift up last night, suggesting more a lack of sellers than a wave of buyers. One exception was Motorola, which jumped over 50% on a takeover offer from Google. “Merger Monday” took a breather but it's back with a vengeance. 

We should remember that lost in the wash of the S&P fiasco has been the ECB's purchases of Spanish and Italian debt – that which had global markets falling before the downgrade. The yield on the Italian ten-year bond was down to 5% last night having hit 6% previously, which can be construed as 100 basis points of relief that the eurozone central bank has got its act together.

Fear over eurozone debt contagion had sent the VIX volatility index in the US to 32 – into nervousness territory – before the downgrade and last night the VIX closed at 31. It hit 48 last week – sheer panic territory – but is now suggesting it was all just a bad dream.

So what has changed? Well, last night the US dollar index fell 0.9% to 73.87, sending gold up US$19.90 to US$1766.20/oz. That puts the greenback 0.9%, or all of last night's move, lower than its pre-downgrade level, yet gold is US$100 or 6% higher. The Swiss franc has been another safe haven for investors of late, but due to stern threats of central bank intervention it is now lower than where it was pre-downgrade. And of course the other safe haven of choice are US bonds.

The ten-year yield last night rose 7bps to 2.33% but prior to the downgrade was at 2.5%. So since S&P suggested US bonds were not worth as much as they were, they are worth more. Let us also not forget that the Fed has supposedly guaranteed zero cash rates out to mid-2013.

If we dismiss the S&P downgrade as an irrelevance, and assume EU officials will be able to allay fears over eurozone debt contagion, what we are left with is reality. And the reality is that prior to all the song and dance over US debt ceilings and ratings, ridiculous media reports about French debt, and emergency Italian cabinet meetings, what the world's markets were concerned about was a slide back into global recession. It's no stretch to assume European growth will be negligible at best given budget cuts, so the real concern has been over the US economy. The data have been trending to the downside and double-dip talk has been back in vogue – just as it was this time last year. Never mind that the US quarterly reporting season now almost over has delivered record earnings growth.

Speaking of earnings, this week and next see the bulk of Australian listed companies reporting their results, and last week saw a pretty good start. Yesterday also delivered solid numbers, and they helped the ASX 200 to a 2.6% rally which, like Wall Street last night, seemed strangely calm. Once again there didn't appear much reason to sell. Perhaps the biggest influence on the Australian market yesterday were the Asian markets, and in particular Japan.

It seems like an eternity ago now, but we might remember that in March Japan suffered a tragic disaster and at the time the world feared a significant global follow-through. Soon fear turned to calm as economists pointed out that Japanese rebuilding will actually be good for the global economy. What nobody correctly predicted was the flow-through impact of the loss of specific components manufactured in Japan, the production of which ceased due to the tsunami. Auto and electronic goods manufacture was most affected, and even the Fed pointed out in its recent statement that it had failed to forecast such supply chain suffocation. This was actually good news from the Fed, for it suggested the central bank saw the impact from Japan as a major factor in weaker US economic data in the June quarter. 

Last night Japan released its June quarter GDP result. Understandably, economists were forecasting a severe hit to Japanese growth and consensus was set at 2.5% contraction. Hence the actual result of only 1.3% contraction was very well received. The Nikkei jumped 1.5% but it was the Chinese who were most excited (they, too, have been hit by loss of Japanese components) with the Hang Seng jumping 3%.

This response was enough to encourage a solid day in the Australian market, and right on cue the local July vehicle sales came out to show a better than expected jump. Those Japanese components are now flowing freely across the oceans once more.

So is it all over now? Was all that hullabaloo for nothing?

It would be foolish to assume the world is not still on somewhat of a knife edge. Tonight the French and German leaders meet in Paris to discuss ways to further ward off eurozone debt issues, and already the expectation is for disagreement. There have been calls from around the eurozone for the introduction of a “eurobond”, meaning a pan-eurozone debt instrument which the ECB can use to monetize debt in the same way the Fed does (QE). Germany is known to be dead against this idea, because as always it would mean Germany effectively lending the rest of the eurozone money it guarantees from German taxpayers. And German taxpayers are getting pretty sick of it.

So in other words, Europe still poses a threat. The US economic recovery could also continue to slow and anything else might happen as well, of course. Gold remains US$100 higher than where it was and US bond yields remain lower because there remains a level of fear in the market.

From a local perspective, earnings reports will become an important driver, as they should be. If the dust can settle, and results come in better than feared, then we should see some stability.

Base metals were mixed on small moves last night in London, and risk trade is back on again with the Aussie jumping one and a half cents since Friday to US$1.0506. With Asia playing leader to, rather than follower of, Wall Street last night, the SPI Overnight is up only 25 points or 0.6% compared to the 2.2% jump in the S&P 500.

There is a wealth of ASX 200 earnings reports out today, and a quarterly update from Westpac ((WBC)) which has the potential to soothe the market further. The RBA minutes will also be released today, but they are effectively pre-hullabaloo so there's not too much point in looking for clues.  

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